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American Eagle Outfitters (NYSE:AEO) plunged recently after the teen apparel retailer reported a sour second-quarter forecast that fell woefully short of analyst expectations. American Eagle’s weak earnings are a dire warning for the rest of the teen apparel industry, since the company had fared slightly better than its troubled peers, such as Abercrombie & Fitch Co. (NYSE:ANF) and Aeropostale, Inc. (NYSE:ARO), over the past year. Should investors stick with these three companies, or are their stock prices set to melt together in the summer heat?

A sad second quarter ahead

For its second-quarter earnings, which will be fully reported on Aug. 21, American Eagle Outfitters (NYSE:AEO) warned that it would only earn $0.10 per share, less than half of the $0.21 per share that analysts had expected. Revenue fell 2% year-on-year, while same-store sales, including its direct-to-consumer channel, AEO direct, plunged 7%. Analysts had expected flat revenue from the prior year quarter.

CEO Robert Hanson attributed the disappointing results to weakness in its women’s apparel segments and weak store traffic. He also blamed a “highly promotional retail environment” which “intensified over the course of July.” However, that promotional environment, which sacrificed margins for more purchases, helped reduce inventory going into the all-important back to school season.

What this means for the teen apparel industry

To understand why American Eagle Outfitters (NYSE:AEO)’s results dragged down Abercrombie & Fitch Co. (NYSE:ANF) and Aeropostale, Inc. (NYSE:ARO), which fell 4% and 2.3%, respectively, after its second-quarter warning, we should look back at last quarter’s top line growth.

Revenue Growth (y-o-y)

Same-Store Sales Growth (y-o-y)

American Eagle Outfitters

-4.1%

-5%

Abercrombie & Fitch

-8.9%

-15%

Aeropostale

-9.0%

-14%

Source: Yahoo Finance, Aug. 7, 2013

During the first quarter, American Eagle Outfitters (NYSE:AEO) fared much better than Abercrombie & Fitch Co. (NYSE:ANF) and Aeropostale, Inc. (NYSE:ARO). A fundamental comparison of these three companies shows that although Abercrombie & Fitch can be considered the cheapest from a traditional PEG and P/S perspective, American Eagle looks the healthiest, thanks to its more robust margins.

5-year PEG

Price to Sales (ttm)

Operating Margin

Profit Margin

American Eagle Outfitters

1.19

1.12

12.49%

6.39%

Abercrombie & Fitch

0.98

0.91

8.73%

5.67%

Aeropostale

4.06

0.50

2.37%

0.52%

Source: Yahoo Finance, Aug. 7, 2013

Unfortunately, those margins will likely be much lower in the second quarter, considering the company’s comments about using increased promotions to drive sales. That’s the same slippery slope that Aeropostale, Inc. (NYSE:ARO) slid down over the past several years, and it’s a very tough decline to climb back from, as seen in the following chart.

The reason is simple — once a brand becomes cheaper, shoppers expect it to stay that way. In addition, a common consensus in the retail apparel industry is that “large logo” apparel, commonly associated with Abercrombie & Fitch Co. (NYSE:ANF) and Aeropostale, Inc. (NYSE:ARO), is no longer popular with teen shoppers, who have since moved on to the trendier fashions of Forever 21 and H&M.

Failing to mind the Gap

A lesson that American Eagle Outfitters (NYSE:AEO), Abercrombie & Fitch Co. (NYSE:ANF), and Aeropostale, Inc. (NYSE:ARO) constantly neglect is The Gap Inc. (NYSE:GPS)’s tiered pricing system. Gap is the parent company of its namesake brand, Old Navy, Banana Republic, Piperlime, and Athleta. Its three primary brands — Old Navy, Gap, and Banana Republic — are respectively aimed at lower-end, mid-range, and high-end shoppers.

American Eagle Outfitters (NYSE:AEO), on the other hand, only has two main brands: its namesake brand and Aerie, which sells intimate apparel and swimsuits for young women. Last quarter, same-store sales at American Eagle fell 4%, but they rose 6% at Aerie. While operating two distinctly different stores reaches a wider demographic, it doesn’t solve the problem of pricing. One of The Gap Inc. (NYSE:GPS)’s core strengths is its ability to maintain pricing power — if shoppers feel like an outfit at Banana Republic is too expensive, they can always go to Gap instead. As a result, Gap reported operating and profit margins of 13.1% and 7.8%, respectively — higher than American Eagle, Abercrombie & Fitch Co. (NYSE:ANF), or Aeropostale, Inc. (NYSE:ARO).